Outside the Box

The Keynesian Depression

February 22, 2013

In today’s Outside the Box, Scott Minerd, chief investment officer of Guggenheim Funds, regales us with the not-always-happy history of Keynesian economics – we did what he said when we had to, but not always when we should have. Shoving fiscal and monetary stimulus down the throat of a recession is well and good, but how about the part where we’re supposed to be fiscally conservative during boom times? “What, raise taxes? No thank you!”

The upshot, as Minerd reminds us, is that “As a result of the constant fiscal support without the tax increases, businesses and households became comfortable operating with continuously higher leverage ratios. The conventional wisdom was that this government backstop could never be exhausted.” Today we are testing that premise to the limit, and not only in the US.

Keynes forged his ideas in the fires of the Great Depression, but his disciples have, as Minerd wryly notes, “carried his views much further than could have been imagined during the period in which the master lived.” Consequently, the downturn we now struggle to escape from is very different from the one that plagued the world of the 1930s. The key difference, Minerd tells us, is that:

… for the first time since the 1930s, we have had severe asset deflation (declining real prices) in the face of relative price stability. Periods of asset deflation occurred between the 1960s and 1990s, but nominal prices were supported by rising inflation levels…. This protected asset-based lenders from severe losses resulting from declining nominal prices.

During the 2008 crisis, inflation levels were close to zero and unable to offset falling real asset values to stabilize nominal prices. This caused a debt deflation spiral to take hold as nominal prices fell. In contrast to the Great Depression, policymakers took extreme measures in 2008 to prevent a total collapse of the financial system and head off a deflationary spiral like that experienced in the 1930s. These policies included sharply increasing the money supply and engaging in an unprecedented amount of deficit spending.

To say the least. And all the easing and deficit spending worked to stave off financial disaster – up to a point. The problem is, we have just about reached that point – the point where, as Rogoff and Reinhart have so firmly instructed us, things turn out not to be that different after all. So let’s jump into Minerd’s take on the big picture, and see what he thinks the implications are for our investments.

But first, let me reveal that I find myself in Palm Springs this morning, getting ready to take a few hours off and embarrass myself with friends at the Indian Wells Golf Resort. Greg Weldon was on the plane last night (at 6’10”, he has to be the tallest analyst in the writing game), and he told me to bring my “A” game to the golf course, as we’d be playing together. I just laughed and said I didn’t even have an “X” game. I think if I shoot anything close to 120, I will just declare victory and walk to the clubhouse with a smirk. Big difference from my attitude in the “old days,” when I had time (and a back) to play. Bottom line: It’s a great course and a beautiful day, and I don’t make my living with a golf club in my hand. Greg, on the other hand, brings the same intensity to everything he does, whether it’s trading or golf or the World Series of Poker. I will watch him exult and curse, maybe on the same hole. I only get intense these days when I write. C’est la guerre.

Grant Williams is in town, and we will be spending a lot of time the next few days comparing notes and doing some videos for our readers (that would be you, and you’ll see them shortly). As everyone knows, I am a huge Grant Williams fanboy. It helps that he is also one of the nicest human beings anywhere.

I am speaking at the Cambridge House Natural Resources Conference here. Rick Rule of Sprott is coming in, and we will have dinner. My Mauldin Economics team partners are also in town, to help with the video and plan out some great new letters. I am really excited about the directions we are taking. They are opening up whole new ways for me to help you.

Oddly, it is colder here in Palm Springs than it was back in Dallas, but pleasant all the same. Have a great weekend.

Your wondering where his ball went analyst,

(The real editor’s note: John apparently finished this on his iPad at the third hole. He was probably not kidding about having lost his ball.)

John Mauldin, Editor
Outside the Box

Get John Mauldin's Over My Shoulder

"Must See" Research Directly from John Mauldin to You

Be the best-informed person in the room
with your very own risk-free trial of Over My Shoulder.
Join John Mauldin's private readers’ circle, today.

The Keynesian Depression

A Premonition From a Halcyon Era

By Scott Minerd, Chief Investment Officer, Guggenheim Funds

In 1968, America was literally over the moon. Apollo 7 had just made the first manned lunar orbit and the nation would soon witness Neil Armstrong’s moonwalk. The United States was winning the war in Southeast Asia and the Great Society was on the verge of eliminating poverty. I remember my father taking me…

Get Varying Expert Opinions in One Publication with John Mauldin’s Outside the Box
Every week, celebrated economic commentator John Mauldin highlights a well-researched, controversial essay from a fellow economic expert. Whether you find them inspiring, upsetting, or outrageous... they’ll all make you think Outside the Box. Get the newsletter free in your inbox every Wednesday.

Discuss This


We welcome your comments. Please comply with our Community Rules.


Brian McMorris 46364174

Feb. 27, 2013, 8:28 a.m.

Ben Bernanke is happy to talk about how beneficial QE has been to the economy and at such little cost.  He will claim that the Fed’s ability to expand its balance sheet has no negative side effects and is producing no excess inflation, and will not do so in the future.  Bernanke reassures us that the Fed can withdraw its accommodation at the right time and without any serious negative consequence. 

How so?

There is very little discussion anywhere in investment, economic or political circles about how the Fed withdraws accommodation.  Any serious thought given to the subject should cause great concern.  The Fed creates accommodation or Quantitative Easing, by buying Congressionally authorized securities.  What is authorized by Congress are US Treasuries and “agency bonds” (GSE mortgage backed bonds).  The funds to pay for these securities are fabricated with bookkeeping entries on the Fed balance sheet.  This is effectively “printed money” that does not exist prior to the event of purchase.  The process of buying Treasury securities effectively lowers interest rates because it increases demand for a fixed supply of those securities, raising the face value of the bonds which lowers the interest rate.

Once the securities are purchased, the Fed is required to place those securities into the banking system.  Banks receive the funds as deposits and can therefore lend against those deposited securities.  A key reason for the Fed to expand its balance sheet is to encourage bank lending to spur the economy.

How is all of this policy reversed?  No one wants to confront the elephant in the room.  Here is what must happen to unwind accommodation: the Fed must shrink its balance sheet back to “normal” levels of 5-6% of GDP from the 20-25% of today.  To do this, the Fed must sell all the securities it has purchased, primarily US Treasuries but also mortgage agencies.  How does this happen and what are the knock-on effects?  The Fed reacquires the securities it has parked in the banking system, decreasing the banking industry’s ability to lend, contracting the economy.  As it sells the securities into the market, who will buy?  Consider that the Fed is currently buying 70-90% of each Treasury auction.  Are there any private buyers of Treasuries who will bid after the Fed has spent several years convincing
the private sector to get out of Treasuries?  At what price (interest rate) will the Treasuries get sold into the private sector?  Surely a lot higher than today:  3% higher, 4% higher?

What happens when the Fed is selling rather than buying?  Not only do interest rates soar higher as the Fed leaves the market as the primary (70%+) bidder, but the funds in the private sector to bid for those securities come at the expense of other asset classes.  Equity prices will thus suffer the loss of bidding and equity markets will drop as they always do when the Fed contracts its balance sheet.  How far?  Considering that the Fed balance sheet has been expanded by $3 trillion on its way to $4 trillion by the end of 2013, and that $3 trillion has been levered up through bank system lending, then more than $3 trillion must eventually come out of other asset classes to buy securities back from the Fed.  The total capitalization of the American stock markets is less than $20 trillion.  If all funds to buy the Treasuries sold by the Fed come from the US equity market, then the equity markets have a long way to fall; the longer the Fed continues its QE the further the stock markets will eventually fall to normalize markets.  Selling begets selling.  As the banks stop lending as they lose capital provided by the Fed, economic contraction will ensue, as it always does: the early 1980 on steroids. 

There is no easy or painless way for the Fed to reverse its policy, contrary to what Bernanke testifies. 

EPual Jacobsen

Feb. 25, 2013, 11:25 p.m.

I agree with the fact of the resultant confiscation, confiscation of those who are “savers” or “responsible”.  Accordingly I detest the manner.

However, even if I provide the benefit of the doubt to the THEORY

I think what is missed is the actual APPLICATION
and accordingly the benefit of the doubt of the THEORY is immediately nullified and we race toward oblivion.

Case and Point - Bright Line ====  Cyprus   ====  Could Keynes have imagined the bailout of the tax haven, or as many may say illegal hiding of assets ? 

You may want to take a peek at this, and if you find interesting I would enjoy your post about it.

Cyprus elections, people seem to have overlooked that.

Anastasiades faces bailout talks after victory in Cyprus elections
ekathimerini.com , Monday February 25, 2013

what Cyprus is claimed to be

Cyprus a channel for attracting investment to Russia
ekathimerini.com , Friday March 16, 2012

In the last five years alone, the Russian economy has seen Cypriot investments of over $52 billion, of which $41.7 billion was invested in the 2007-10 period, or 2.7 times more than German investments in Russia in the same period.


others say perhaps an illegal tax haven


Does the US and EU bail out Swiss banks holding “secret” accounts for rich US taxpayers? 
Does or will US and EU bail out Bahamas and other offshore banks holding “secret” accounts for rich US taxpayers? 

This could get interesting. Will the Germans agree to effectually bail out Russian wealthy ?
Will the rest of the EU ? Will US chime in through QE and IMF ?


As we bail out the illegal under the guise of a Keynesian assist
we fall deeper and deeper into the sandhole, and the sides keep
caving in despite the depth we dig.

Michael Schwartz

Feb. 25, 2013, 1:44 p.m.

Reinhart and Rogoff indeed tell us that ‘this time is not different’ - the difficult question is ‘what are we not different from?’ Are we not different from 1928 when the over-leveraged economy was due to crash, or are we not different from 1936, when too-soon austerity led to years more of depression?
You quote them saying:
...Highly leveraged economies, particularly those in which continual rollover of short-term debt is sustained only by confidence in relatively illiquid underlying assets, seldom survive forever, particularly if leverage continues to grow unchecked.
While the US economy was certainly over-leveraged in 2007, there has been a huge amount of de-leveraging since then - both in the private sector and in the non-federal government sector. The increase in debt by the Federal government has not been any where near enough to balance this deleveraging. So US leverage does not ‘continue to grow unchecked.’
And while the economy in 2007 was partly sustained by overconfidence in illiquid housing assets, it is hard to see how that is true of today’s government debt.
Reinhart and Rogoff also point out that in the aftermath of financial crises, government debt almost always increases sharply. As John Mauldin often points out, it is mathematically true that if the private sector deleverages (and the balance of payments stays about the same) then the public debt must increase. In Reinhart and Rogoff research, this public debt increase is a normal and almost necessary part of the recovery from a financial crisis, as a way to sustain private deleveraging and prevent total financial meltdown.
So if today is ‘not different’ from other examples of post-crisis recovery, the proper policy is continued government support for private deleveraging, with solid plans laid for long term government debt reduction. Short-term austerity just makes us ‘not different’ from 1936, and liable for more unneeded economic pain.

Ski Milburn

Feb. 23, 2013, 10:56 a.m.

Whoops!  I can see that commenting while fixing dinner and drinking wine can induce a certain dyslexic aspect.  Should have read:

“Keynes proposed that we dampen the wild swings of the business cycle by running deficits in bad times and surpluses in good times.”

Another minor correction upon reflection.  In Russia “everyone” had too many rubles and no inventory, in America, “everyone that counts” has too many dollars and no returns.

But my conclusion stands.  We’re all Naissur’s now.


Feb. 23, 2013, 6:22 a.m.

I do not hold Lincoln in such high regard as you. We were the only country that required the killing and maiming of one million Americans to abolish slavery. And even following that long, arduous war, discrimination and slavery was not abolished by the stroke of a pen. I believe the War between the states was the the greatest usurpation of our Constution in history and led to our untamed federal governmental largess today. Many historians think that the southern states would have reunited with the union prior to the 20th century without the killing and maiming of one million Americans. And our founding fathers thought that secession was permissible, if you look at their original statements and facts surrounding ratification of our constitution. Why do so many allow cultural myth to debunk historical facts? I realize trampling on the Lincoln Legacy may put me at odds with a few, but so be it. The truth will set us all free. You could use a better example than Lincoln. His own words betray his real racist character, if you are familiar with what he actually said.

Gordon Davis Jr

Feb. 23, 2013, 3:17 a.m.

If Japan is any indication of what is possible, we should be able to expand the national debt by at least another order of magnitude or so. As for the Fed balance sheet, does anyone really know what the practical limits are? We have only a few years left of relative deficit stability.  Then, our unfunded liabilities will kick in with a vengeance. No where near enough time to allow the Fed to begin unwinding. The reality is we have already chosen our path of increasing deficits, growth of the Fed balance sheet and the long term devaluation of the dollar.


Feb. 23, 2013, 1:30 a.m.

You wrote:Much like that crisis needed Lincoln, the current crisis needs someone who can identify new tools to resolve the present economic crisis. Until then we are condemned to a path which leads to further currency debasement and the erosion of purchasing power, with the result being a massive transfer of wealth from creditor to debtor. Without a new economic paradigm, the deleterious consequences of the current misguided policies are a foregone conclusion.

Well, how are ‘new paradigms’ invented or recognized?  It is very difficult since everyone involved is inside the current one.  You cannot ‘think outside the box’ as is so often said.  Thus, we are stuck right now because there is nothing of significance on the horizon that would qualify for “new paradigm” status because the whole world is in essentially the same ‘box’, some more so than others. 

We should be looking outside the field of economics to find our way forward.  What is emerging science or new understanding in the fields of biology, astronomy, sub-particle physics, etc. that might point the way towards a system of deeper mutuality, support and general well-being?  Better brains than mine need to ponder how we observe ourselves from Mars, having never been here before.  That is what is required. Spending isn’t going to work, austerity is not working where it is being tried; these are the poles of the continuum and the solutions won’t be found there.  How might fractal mathematics inform our economics? How might Open Space Technology inform economic policy?  How might Positive Deviance cause people to discover what works?

I don’t know the answers to those questions but I do know those inside the system are highly unlikely to change it.  “Prudens quaestio dimidium scientiae”—-to ask the proper question is half of knowing. We need to discover the proper questions.

Hang emhi

Feb. 22, 2013, 10:14 p.m.

Google “rogoff and reinhart reverse causality”.  Economies in trouble end up with high government debt, it is not the other way around.  “This Time is Different” should have been called “Lies, damn lies and statistics” especially since it has gone so mainstream largely because the know-nothing deficit hawks (most of the country) finally got the “proof” they needed since there is no other existing proof that austerity does anything other than turn recessions into depressions. 

Meanwhile, there is a new economic paradigm.  Several competing schools from Monetary Realism, to MMT, to Positive Money to the Circutists have identified that Keynes, and therefore just about every mainstream economist today don’t realize that money is created upon the issuance of a loan, and therefore private sector debt levels are what should be monitored if you want to know when economic collapse is coming.  Further, debt of a nation sovereign in its own currency will never go bankrupt and can borrow essentially forever - a government deficit is a private sector surplus, so they are creating their own demand - the more debt they issue, the more money available to buy their debt.  Before thinking we can issue debt to eternity and make everyone rich, the constraints are inflation, crowding out and incentivizing something for nothing.  We’re committing all kinds of mistakes today, but one of them is not the US gov debt level, except of course the spending that does the above 3 things.  By not understanding private sector debt, and therefore focusing on the most benign debt, gov debt, with idiotic papers from statisticians who clearly don’t know debt either, we’re only exacerbating the problems.


Feb. 22, 2013, 8:21 p.m.

What we should have is a Keyensian variable value added tax which has the rates tied by law to GNP growth.  This would be automatically countercyclical and would not be subject to political interference without a large consensus.  The idea is illustrated in the table below but the rates are just examples.

Keyensian VVAT Plan.

Variable Value Added TAX

GDP Growth vs Tax Rates

-3 %    -8%
-2 %    -6%
-1 %    -4%
0 %    -2%
>0% <3%  0%
3 %  2 %
4 %  4 %
5 %  6 %
6 %  8 %
>7%  10 %

If scheme starts in a recession then the negative payments are paid by selling Key VVAT bonds, all tax revenue from the VVAT must be any used to pay off existing VVAT bonds.

After any existing Key VVAT bonds have been paid off all tax revenue is “paid” into Key VVAT savings up to 10% of GDP (= two years payout in an average recession) for use in the next recession.

Revenues > 10% GDP and < 30% of GDP are paid into Key Infrastructure savings accounts and may be used in the next recession on public infrastructure projects.

Revenues > 30% can be used to reduce the deficit and/or debt.

Ski Milburn

Feb. 22, 2013, 7:53 p.m.

Keynes proposed that we dampen the wild swings of the business cycle by running surpluses in bad times and deficits in good times.  My take on his idea was that budgets would be roughly balanced in the long run as a result.  Well, our politicians only learned the first half of the lesson, and so in 1981, with the inaguration of President Reagan, we entered the age of permanent deficits, and continuous stimulus.

It was a good way to jack up our economic growth rate and obliterate the Russian threat, but along the way we got addicted to deficits like a Wall Street tycoon with a cocaine “problem”.  Maybe we’ll stop tomorrow, but right this minute, all we need is a little more blow.

Well, it’s morning in America, but we’re looking at it from the wrong end of the day.  Our bag is empty, and our connection is telling us we’re bumping into our credit limit.  Happy to make a seven a.m. delivery, but he wants cash this time.

We’re all Russians now.  Everybody has more money than they know what to do with, but they can’t buy anything worthwhile with it because nobody knows what anything is worth anymore, or what the future will hold.  Meanwhile, the government is listening to every form of communication, and we’ve abandoned due process in favor of issuing Executive Orders to kill Americans.

Don’t worry about it.  Every cloud has a silver lining, and this too will pass.  Look at Russia, the successor state to the USSR, and a bunch of spinoff states with names, not initials.  Same thing coming to the USA, and sooner than you think.

We’re all Russians now.